Markets Not Ready For A Fed Surprise
The Fed’s minutes and statements by a number of senior officials seem coordinated to suggest that the March meeting is a live possibility for the next rate hike. This is in keeping with the Fed’s behavior in recent years of trying to prepare the market for each policy change. This time, the message hasn’t been definitive. But the sentiment could be quickly reinterpreted if the February employment report, scheduled for this coming Friday, shows clear evidence of additional scarcity of labor.
Janet’s Yellen’s semiannual Congressional testimony expressed the view that the labor market is already at maximum employment and that the Fed cannot refrain from normalizing interest rates without taking on greater of risk of rising inflation that forces it to play catch-up, thereby risking pushing the economy into recession. So, “further adjustment of Fed funds would be appropriate” if employment and inflation continue to meet the Fed’s expectations. Also, “it would be unwise” to wait too long to raise rates. These statements actually set a low bar for another rate increase.
Even so, the market wants to believe the Fed will only increase interest rates gradually over an extended period of time, despite the implicit requirement that the Fed must be data dependent and will be unable to deliver gradual rate increases if the labor market quickly becomes tight, labor costs accelerate, and inflation follows suit. The market prefers to take solace in the views of the Fed’s doves, who prefer to run the economy hot in order to promote more hiring and faster wage growth for less skilled, lower wage workers. That position is simply unsustainable. It unravels as quickly as the tight labor market causes inflation to accelerate. In fact, except for the Fed’s preferred inflation measure, the “core” personal consumption deflator, every other inflation measure already exceeds the Fed’s 2% target. And the Fed’s preferred measure is now approaching the 2% target.
Investors took some solace from the last employment report, which showed a sizable increase in labor force participation, which added new workers to the labor market and relived some of the brewing wage inflation pressure. But for demographic reasons, labor force participation is trending down, so the one month uptick may have been a simple oddity of the survey process. If it reverses in the next report, or is revised away, the unemployment rate could decline more sharply, rendering labor even scarcer. Thus, the next jobs report might be very important for the Fed’s March 14-15 FOMC meeting.
The market has priced in just two rate hikes this year, not the three suggested by the Fed’s last projection. And odds of a rate hike occurring in March are only about one-third. So, investors remain relatively complacent in the face of a low unemployment rate and repeated suggestions by senior Fed officials that another rate hike could occur fairly soon. It wouldn’t take much, in our opinion, to push the Fed over the edge. Either another strong jobs report or another high inflation report would probably be sufficient. Investors should think of most every meeting as live. They don’t, which suggests that some market volatility might also occur. Long-term bonds are at particular risk, while equity sectors that are exposed include traditionally “safe” bond surrogates like utilities and real estate investment trusts, as well as consumer staples.
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